The Fed, the Money Supply, and the Economy

You have probably heard news stories or read headlines about the latest moves by the US Federal Reserve (“the Fed”) to adjust the money supply, to raise or lower interest rates, or to otherwise attempt to adjust the fundamentals affecting the economy. Though these discussions can seem technical and difficult to understand, there are really only a few basic tools at the Fed’s disposal in its efforts to keep the economy on track and growing. They are potentially very powerful tools, but they all revolve around how much money is in circulation in the economy. The Fed attempts to discern which direction the economy is going, and then it uses its ability to affect the money supply to either encourage or discourage that direction.

Discount Rate. This term refers to the rate charged by the Fed on short-term (usually overnight) loans between banks. In order to maintain their required reserve ratios (more on this later), banks will sometimes borrow money on a short-term basis. The interest rate on these loans is regulated by the Fed. When the rate is low, the Fed is encouraging the loans, thereby increasing the amount of money (“liquidity”) available. When the Fed raises the discount rate, as it has been doing recently, it makes the loans more expensive, which tends to decrease the available liquidity. When you hear references to “Fed easing,” it often means that the rate is decreasing (which increases liquidity). When you hear that the Fed is “tightening,” it means that the discount rate is increasing in order to slightly shrink the money supply.

Open Market Operations. In addition to controlling the rate on interbank loans, the Fed also sometimes buys or sells US Treasury securities in the open markets. Because US Treasury securities are backed by the full faith and credit of the US government, they are considered to be among the world’s safest investments. US Treasury securities can be short-term (six months or less) or long-term (up to thirty years). Owners of Treasury securities essentially loan money to the US government, which pays them interest for the term of the loan and then repays their principal at the maturity date. When the Fed buys Treasury securities on the open market, this has the effect of increasing the amount of money in circulation, adding to liquidity in the economy. On the other hand, when the Fed sells Treasuries in the open market, it decreases the money supply; this is another form of “tightening.”

Reserve Ratio Requirements. This is perhaps the most powerful tool the Fed uses to control the money supply. Banks are required to maintain a certain percentage of their assets as a reserve against deposits. When the Fed wants to increase the amount of money in circulation, it lowers the reserve requirements, allowing banks to lend a larger percentage of their assets, thus adding liquidity to the economy. When the Fed wants to decrease the money supply, it raises the reserve requirements, which means that banks must keep more of their assets in reserve, with less available for lending. Because this tool has such an immediate effect on the liquidity of the economy, the Fed uses this technique sparingly.

In general the Federal Reserve seeks to carefully calibrate the money supply to encourage growth without allowing inflation to get out of control. As a result, banks and other financial institutions pay close attention to the actions of the Fed, as described above, and even the speeches and other comments of the chair and other officers of the Federal Reserve system, in order to stay abreast of what the experts at the Fed believe about the economy and the money supply.

Stay Diversified, Stay Your Course!

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